COLUMN-Fed 'put' no cause for relief: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

Aug 25 (Reuters) - Future (Other OTC: FRNWF - news) risk-adjusted returns look poor from here, but if the Federal Reserve deploys its safety net they will be worse still.

Monday's savage markets selloff inevitably brought with it rising expectations that the Fed would once again swoop in to the rescue, this time by delaying, perhaps indefinitely, a September hike in interest rates.

Be in no doubt, this is the fabled 'Fed put,' the self-reinforcing idea that the U.S (Other OTC: UBGXF - news) . central bank will act as safety net and uncompensated insurance agent to private risk takers.

And it worked, as it has since the days it was known as the 'Greenspan put', a description of how the Fed would provide liquidity and reassurance in bad times but do little to stand in the path of rallies.

Stocks on Monday first plunged, with the Dow Jones industrial average falling more than 1,000 points, or 6.42 percent, at the opening then recovering nearly 900 points only to move lower to end the day down 588, or 3.58 percent.

Unsurprisingly the CBOE Volatility Index, which measures how sharply investors expect stocks to move, surged by as much as 90 percent to more than 50, its highest since January 2009. The VIX is sometimes called the 'fear index' because investors use volatility as a key metric of risk.

"There is a growing chorus that the Fed needs to bail the market out yet again and delay rate hikes, using the 1937 analogy whereby early tightening resulted in a recession and massive decline in the Dow Jones Industrials," Michael Gayed, chief investment strategist at Pension Partners, wrote in a note distributed to contacts and clients as stocks opened.

"This is complete and utter insanity. If all it takes is three days of stock market declines to cause everyone to flip their opinion on Fed policy direction, then we are in a shockingly fragile environment."

And so must we be, because as the streak built to its fourth and most volatile day, traders have downgraded expectations of a Fed hike at its September meeting to only about one in four, down from about one in two less than a week ago.

Economists were quick to backdate their calls on when the Fed will move. Barclays Bank shifted its call from September this year to March next year, citing financial market conditions.

VOLATILITY CAN ONLY BE SUPPRESSED

The Fed may choose to wait, and of course what is happening in markets is telling us something about economic conditions, particularly in China, which is rapidly slowing.

That said, a market which recovers because the Fed comes to the rescue is not one you should want to buy.

Firstly, while the Fed has shown it can suppress volatility through policy, that suppression seems to affect the distribution of volatility rather than its existence or quantity. We tend to get long periods, such as the one we may just be coming to the end of, during which volatility is unnaturally low. That encourages risk taking, but that risk taking will tend to concentrate the suppressed volatility in hands not capable of analyzing or managing it. In other words, silly people do silly things with money because they believe the Fed has their back.

Passing on a modest hike in rates with the unemployment rate at 5.3 percent will only reinforce that cycle, regardless of what is happening in China.

Secondly, an investor-saving Fed might goose returns now but cannot do much about the longer-run potential of companies to create cash flow. Stocks, and bonds, now are not particularly attractive and don't show much promise of handsome returns over the medium term.

Using a Shiller price/equity ratio, which compares stock prices to a 10-year moving average of earnings, stocks are now quite expensive in a historical context. Even (Taiwan OTC: 6436.TWO - news) after today's sell-off, the S&P 500 is at a Shiller p/e of 24.21, a bit below where it went into the financial crisis of 2008 but below its peaks in 1929 and 1987.

Value investment house GMO, for example, is forecasting negative real returns over the next seven years for most major asset classes, with the notable exception of emerging stocks and bonds.

Arguably resource allocation will be worse because of an overly soft approach to managing markets, not better. That means that if we escape a correction due to Fed forbearance we should be less optimistic about future returns, not more.

In some ways the central bank is making the same mistake with investors that parents seem set upon doing with their children: mowing down all obstacles in their way and relieving them of responsibility and opportunity to grow.

Perhaps the Fed should stop preparing the path for the investor. You never know, it might work. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft) (Editing by James Dalgleish)